The Daily Fix - Inter-Market Analysis and Macro Insights

Politics is a factor we as market participants have had to contend with for many years now, and right now we can see a number of clear political thematic’s driving investment and capital flows and these have so much further to play out.

We have had to contend with Italian political news flow, and as things stand the budget negotiations are seemingly on the back burner, with Italy BTP/German yield spread back below 300 basis point and we can all sleep well again. Moving on, and the topic du jour surrounds the US Midterms, and the playbook here is dependent on the two higher probability outcomes. The new news being debated around the desks today is a world where Angela Merkel is no longer the glue that holds Europe together. Whoever comes into the role of German Chancellor, whenever that may be, has some incredibly big shoes to fill and she has been a powerhouse of global politics for many years.

Most likely we will be debating Merkel’s replacement for some time in the future, but we are staring at a situation where perhaps Merkel’s replacement is not the poster child of fiscal discipline and frugality we have come to know and respect. Perhaps the individual may even utilise the current account to promote even further economic growth. That said, in true European style we need to be more readily focused on early elections, and more broadly this story raises the European political risk dial a touch.

Of course, we also still have the ever-growing prospect of a ‘no deal’ Brexit to contend with, and the chorus of voices grows ever louder that Britain will be more likely than not to cross the Rubicon and the period when GBP becomes far more volatile. Certainly, this was case-in-point yesterday with rating agency Fitch detailing a higher probability that the UK’s sovereign rating is lowered on the potential disruptions from a ‘no deal’ world. GBPJPY has been my preferred vehicle for expressing this thematic, although a focus on the four-hour chart and we can see a shift in momentum of late and I see risks we could see the 145.30/40 area comes into play - where I see a far more compelling zone to re-apply short positions.

While Brexit is both frustrating and fascinating at the same time, its perhaps the US Midterms that interests most right here, as the ramifications could be pronounced and could test the logic of efficient market hypothesis and the notion that markets have fully discounted all known news. As we saw from yesterday’s Gallop poll (sample size of 1500 adults), Trump’s approval rating has taken a hit largely as a result of the various acts of extremism. This only solidifies the notion of a split Congress and with-it new frustrations for investors hoping to see various fiscal measures passing into law. Not that the market was ever truly discounting infrastructure or permanent tax cuts anyhow.

Gallop weekly poll on Trump Approval/Disapproval

(Source: Bloomberg)

We are going to see a barrage of negative headlines, which is not going to do the USD any favours at all. So, be it the re-opening of the House investigation into Russian involvement in the 2016 election, Trump taxes, or even the debt ceiling saga, it's fairly safe to say there will be significant legislative issues impacting traders’ psyche.

I talk about efficient markets because the outcome of a divided Congress should, in theory, cause limited moves in markets. If we use USDJPY as one proxy, we can assess two-week USDJPY implied volatility and see options markets pricing a 123-pip move in USDJPY (in either direction) through the coming two weeks. Hardly a market screaming out that the Midterms are going to jolt the FX markets closer to the sort of volatility we have seen in the S&P 500 for example and that appears logical given the Democrats have held at least a seven percentage point lead in the generic poll since September.

If anything, we can argue that if we saw risk aversion in overnight US trade was premised on the news that Trump wants to place tariffs on the remaining $257b of China’s exports (to the US), then a split Congress severely weakness his ability to pass this tax – do we all buy risk assets then? Granted, Trump’s trade representative’s will be the architects of any new tariffs, but Trump needs the blessing from both chambers of Congress and that ain’t going to happen. Anything that gives Trump a fighting chance of retaining his presidency in 2020 is going to find it hard to see the light of day.

So, while Trump can push to pass legislation in the interest of national security, in effect, who benefits from political gridlock? Emerging markets seem to tick a few boxes and could be the main beneficiary, and China would be hoping that the Democrats destroy Trump in the House. Whether this is the trigger to buy EM assets is yet to be seen. Perhaps it makes sense to hold off until after tomorrows chunky SoMA (System Open Market Account) redemption, where the Fed’s balance sheet will be reduced, and where previous reductions in USD liquidity have been a consistent USD positive throughout 2018. We also have month-end to navigate, where most flow/rebalancing models estimate a significant level of USD buying.

However, if we look at EURUSD and the USD index we can already see exhaustion in the trend and the tides seem to be turning in many of the momentum and trend oscillators. We haven’t been handed a buy signal in EURUSD just yet, but it’s not far off. One to watch, but if EM is going to find a better tone on a less powerful Trump, then it makes sense to buy the AUD, where the six-month correlation coefficient between AUDUSD and the Hang Seng sits at an incredibly higher 0.87. So, tell me where the Hang Seng is going, and I’ll let you know where the AUDUSD is headed. Either way, a close through 0.7160 puts bullish divergence in play, and I would be long, adding a break of the 55-day moving average at 0.7190, for a move into 73c.

All of that said, we can go back to a well-known saying coined by German philosopher Friedrich Hegel, that ‘the only thing we learn from history is that we learn nothing from history’. We have simply had too many case studies where the expected proved to be wholly incorrect, so we should never be complacent of a sure thing. If we are to learn from history, it is to not be shocked of a Republican clean sweep, especially when there are too many battleground states within the margin of error and where voter turnout will be a strong consideration.